American Electric Power Company (NASDAQ:AEP) Use Of Debt Could Be Considered Risky

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that American Electric Power Company, Inc. (NASDAQ:AEP) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for American Electric Power Company

What Is American Electric Power Company's Debt?

The chart below, which you can click on for greater detail, shows that American Electric Power Company had US$43.6b in debt in September 2024; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

How Strong Is American Electric Power Company's Balance Sheet?

According to the last reported balance sheet, American Electric Power Company had liabilities of US$10.6b due within 12 months, and liabilities of US$62.8b due beyond 12 months. Offsetting these obligations, it had cash of US$474.4m as well as receivables valued at US$2.72b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$70.3b.

Given this deficit is actually higher than the company's massive market capitalization of US$51.9b, we think shareholders really should watch American Electric Power Company's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in American Electric Power Company like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Fortunately, American Electric Power Company grew its EBIT by 3.6% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if American Electric Power Company can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, American Electric Power Company burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, American Electric Power Company's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. It's also worth noting that American Electric Power Company is in the Electric Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like American Electric Power Company has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for American Electric Power Company you should be aware of, and 1 of them is potentially serious.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.